Explaining How Global Trade and Financing Really Does “Balance”ARTICLE

By Tim Worstall

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When it comes to global trade and financing, nothing mystifies people – even well-educated businesspeople – quite as much as the concepts economists use to discuss them: trade balances and the balance of payments. Even a fleeting look at normal institutional discussions of these matters shows they can be controversial, which often indicates that one or both sides in a discussion doesn’t quite grasp all the concepts. Yet the every-day flow of news and other relevant business information continuously discusses trade balances and the balance of payments, so the following explanations may provide readers with a valuable foundation for enhanced understanding and improved business decision-making.

The most important point to grasp is that global trade and financing really does “balance”. Always and without exception, the balance of payments is “in balance.” Confusion creeps in when people consider one or more of the components comprising that balance without noting that they are just that – subsets of a country's global trade and financing, not the totality. The totality of the balance of payments is all of the flows of money in and out of the economy. One part of this is trade, another is the movement of capital for investment purposes. The whole is always in balance, whatever the surpluses or deficits of the various constituent parts.1

And of course, the global trade and financing figures should always balance. After all, other than the occasional spacecraft splashing down on Mars, we don't trade anywhere other than with each other here on Earth.

The Building Blocks of Global Trade and Trade Financing

To build a complete picture of a country's global trade and financing usually starts with trade in goods. Trade in goods counts up the value (economists always are concerned with value, not volume) of physical items traded across borders, both exports and imports. This results in the “goods trade balance.” As an example, the United States today runs a goods trade deficit of about $800 billion a year.2 This means that the U.S. buys $800 billion more of physical things made by foreigners than foreigners buy of physical things made in the U.S.

Next, the “services trade balance” adds up exports and imports of non-physical tradeables, such as legal services. Here, the U.S. has a surplus of roughly $300 billion, since foreigners buy a lot more U.S. services than the U.S. buys foreign services.3

Adding goods and services together results in the “trade balance.” For the U.S., this is roughly $500 billion in deficit, since surplus in services exports doesn't offset all the physical imports.4

The next element required to balance the totality most directly concerns financing rather than global trade. This is the income account – the profits earned in the USA from foreign investments minus the profits made by foreigners on investments in the U.S. Interestingly, Americans tend to make higher profits on their foreign investments than foreigners do on their U.S. investments.5 As an example, someone in the U.S. might own Venezuelan bonds paying 7 percent, while a foreigner owns U.S. Treasuries paying 1 percent. Clearly, the American is earning more on Venezuelan bonds than the foreigner is earning on U.S. Treasuries, so the net income for the U.S. is positive. Adding in this net number reaches the “current account balance.”

Despite positive net investment income and a trade surplus in services, the current account balance is, for the U.S., still negative.6

Global Trade, Import And Export, Is Only Half The Story

Hold on! Remember, the balance of payments always does balance. There is another side to the story: the “capital account.” This will always, barring a few timing differences, balance the current account.

The capital account is the flow of investment across borders. This could be into land, property, stocks or bonds, but the total amount will always be equal and opposite to that current account. The underlying logic is that U.S. dollars are only really useful in the U.S. So, when businesses send dollars off to buy foreign goods they eventually must come back somehow. And if they're not coming back to pay for goods or services then they must be coming back as investments.

It's worth noting that these are all accounting definitions. The reality of global trade and its financing can be a little more confusing. For example, as the economist Scott Sumner likes to point out, if we build a mobile home in Wisconsin and sell it to someone living in Korea, then that's obviously a goods export. It's a mobile home, a physical good, that goes on a ship to Korea from the U.S. But if we sell that same mobile home in Wisconsin to an immigrant newly arriving from Korea, then that's not an export, that's a capital account transaction. The accounting is very different, but the underlying economic reality isn’t. Work has been done in Wisconsin which results in a Korean sending dollars into the U.S. to pay the people who did that work. Those dollars, in either case, come from the money sent outside the country to pay for imports.7

The capital account for the U.S. is in surplus and has been for decades. So, foreigners invest more in the U.S. than U.S. people do elsewhere. As previously stated, this must be so because the balance of payments does balance and always will.

The Takeaway

The economist Adam Smith said, “Nothing, however, can be more absurd than this whole doctrine of the balance of trade.”8 Since Smith is widely regarded as the founding father of modern economics, it is unsurprising that many modern economists tell us not to worry about trade deficits. The balance of payments does, in fact, balance.

The Author

Tim Worstall

Tim Worstall is a British writer on business and economics whose work has appeared in The Times, The Daily Telegraph, The Guardian, The New York Times, The Wall Street Journal and numerous other publications. He is currently a regular contributor to Forbes. His past business activities include exporting rare earths from Russia and producing video games. He is a Senior Fellow at the Adam Smith Institute in London.

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